Rate-sensitive borrowers weathered December rate hike

Many rate-sensitive borrowers actually did better than expected after the Federal Reserve's December rate hike, but that doesn't guarantee they will also be able to dig deeper as rates continue to meander upwards.

Most borrowers were able to absorb the higher monthly credit payments that came after the Federal Reserve Board’s interest rate hike of 25 basis points last December, according a new study by TransUnion released this week.

Prior to the rate increase in December, TransUnion conducted analyses to determine which consumers were most likely to have difficulty making their monthly payments after interest rates rose.

“You can take a group of people with clean credit, and a few months later some will be delinquent; that’s just natural movement,” says Ezra Becker, senior vice-president of research and consulting at TransUnion. “We wanted to know how much of that would be driven by rate increases and not by other factors.”

So in November before the rate increase took effect, TransUnion used its CreditVision aggregate excess payment (AEP) algorithm to identify 10.6 million consumers, out of 63 million carrying debt tied to market interest rates, who would be at elevated risk of default on monthly credit payments after the interest rate rose.

At the end of March, after the December rate hike had time to show an effect, analysts compared the consumers deemed at-risk to a control group that had no variable-rate products. (The Fed raised rates subsequent to December, in March and June of this year. The research did not address that.)

Becker says the company was surprised to find that “of the 10.6 million we thought were at elevated risk of default, only about 1 million were delinquent.”

In fact, Becker adds, the control group fared worse: 5.6 million (13%) were delinquent on at least one credit product by the end of March.

“When you compare the test group to the control group, delinquency rates for the test group were actually lower,” Becker says. “So we do not believe that the 0.25% increase caused a material impact on consumers being able to cope with their payments.”

Conservative measures, varying factors

One explanation for the unexpected results is that TransUnion employed a very conservative algorithm to predict which consumers would be at risk.

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Nidhi Verma, senior director of research and consulting for TransUnion, explains that CreditVision analyzed up to 30 months of mortgage, credit card, and other debt payments and calculated the amount a consumer paid beyond the minimum due. If the consumer’s AEP was lower than the projected increase in their payments following an interest rate increase, TransUnion concluded the consumer might not have the capacity to absorb the payment hike.

“[AEP] is essentially a calculation of a consumer’s behavior,” Verma said. “We look at how much you’re paying. Some consumers pay a little more to lower their credit obligation. They’re already overpaying their debt, so we know they can tap into that excess payment and absorb an increase.”

What AEP doesn’t take into account is contributions made to savings or investments, Becker says, and many more consumers than expected evidently were able to draw on those or other funds.

Predicting financial strain is inherently difficult because so many factors are in play.

“It’s not just the interest rate; it’s how much you owe overall,” Becker says. “If someone racks up a lot of debt, payments go up even if the interest rate doesn’t.” Moreover, financial distress can be random. “They might have lost their job and would have been unable to make payments even if rates hadn’t gone up,” he says.

TransUnion adds that this study analyzed only the immediate effects of the interest rate increase, and a greater impact may be revealed over the long term.

“If you didn’t go delinquent this month because you dipped into savings or borrowed from family—or even if you didn’t dip into savings but had to stop making contributions to a saving or investment account—that’s still slowing down your wealth-building process,” Becker says. “If you have to slow that down, there’s a long-term impact that would not be apparent in this study. It might not drive immediate delinquency, but we also want consumers to be able to pay for their future.”

Caution advised for lenders and borrowers

The TransUnion study analyzed the recent increase of 0.25%, but the effects of a higher rate increase remain unknown.

“A larger increase could have a more material impact, but I don’t know what that would be,” Becker says. “The estimate we were using was very conservative. We’d have to ask what else is going on in consumers’ lives.”

The most important takeaway from this research for both lenders and consumers, he says, is that a rising interest rate environment is fundamentally different from the experience of recent years. Until the increase in 2015, the Federal Reserve Board had not raised interest rates since 2006.

“Lenders now have to remember that consumers actually can face payment shock,” Becker says. “Individual consumers may be more risky as a result, and we haven’t had to think about that for a while. We’re in an environment where there are more rate increases, and they may be larger and more frequent, so lenders need to plan for them.”

That includes reminding customers that they, too, need to plan when interest rates and payments rise. “It might be as simple as eating out one less time per month,” Becker says. “It might mean a more material change in their lifestyle. Awareness and planning are the key for both lenders and consumers.”

Handling outstanding debt versus taking on new

Part of the broader picture drawn from TransUnion’s research is that even though consumers seem to be able to absorb a 0.25% interest rate increase on existing debt, that doesn’t mean that new credit can be as easily absorbed.

“If you have a 30-year, fixed-rate mortgage, it doesn’t bother you if interest rates go up,” Becker says. “But an increase on a new mortgage can really change how much you have to pay. If the interest on a fixed-rate, 30-year mortgage of $200,000 goes up from 4% to 4.25%, that’s a $10,458 increase.”

The job of lenders is to identify and evaluate risk and build strategy to manage that risk, Becker says, and TransUnion’s research demonstrates the need to ask what that means for your bank’s portfolio.

Can lenders evaluate clients’ vulnerability to rising interest rates? “Our study shows that it’s not a big risk in the short-term, but that doesn’t mean this should be ignored,” he says. “Part of our job is to help lenders understand risk. This is a new risk that doesn’t exist in a falling-rate environment.”

Melanie Scarborough is a contributing editor for Banking Exchange magazine and www.BankingExchange.com. She is based in Washington, D.C.. Scarborough was senior editor of Community Banker, where she received the APEX award for feature writing, and a regular contributor to ABA Banking Journal. Melanie previously was an associate editor of the Richmond Times-Dispatch in Richmond, Va., and a monthly columnist for the Washington Post.